Secondary Markets
1

Stock Exchanges
 NYSE
 Amex
 Regional

exchanges
The Over-the-Counter Market
 An
informal network of brokers and dealers
 NASDAQ: A computer linked price quotation system
Order Types
2


Market buy: buy at best going price
Market sell: sell at best going price
When price
does this:
Sell
Stop-loss
(Stop-sell)
Limit sell
Buy
Limit Buy
Stop Buy
3
Bid-Ask Prices



The ask price is the price at which someone stands
willing to sell.
The bid price is the price at which someone stands
willing to buy.
Ask>Bid (always)
Bid-Ask and OTC Markets
4

On Over-the-Counter markets:
 Only
dealers post bid-ask prices.
 All buy orders buy at ask (the higher price)
 Market
buy
 Limit buy
 Stop buy
 All
sell orders sell at bid (the lower price)
 Market
sell
 Limit sell
 Limit buy
Bid-Ask and OTC Markets
5

Ask: 45.60 Bid: 45.50

Market Buy
 Buy

at 45.60
Market Sell
 Sell
at 45.50
Bid-Ask and OTC Markets
6

Ask: 45.60 Bid: 45.50

Limit Buy at 45.55
 Order
not executed. Buy price (45.60) has not dropped
below the threshold (45.55)

Limit Sell at 45.55
 Order
not executed. Sell price (45.50) has not jumped
above the threshold (45.55)
Bid-Ask and OTC Markets
7

Ask: 45.60 Bid: 45.50

Stop Buy at 45.55
 Order
executed immediately. Buy price (45.60) is
above the threshold (45.55)

Stop Sell (Stop Loss) at 45.55
 Order
executed immediately. Sell price (45.50) is
below the threshold (45.55)
Trading on OTC Market
8



Investor places an order with broker.
Broker tries to locate the dealer offering the best
deal.
Trades are negotiated through dealers who
maintain an inventory of securities.
Trading on Exchanges
9

Investor places an order with broker.

Brokerage firm contacts floor broker.

The specialist “makes a market” in the shares of one or more
firms



Maintains a limit order book.
Can act as both a broker and a dealer
Maintains a “fair and orderly market” by dealing personally in the
stock.
Bid-Ask and Exchanges

Any limit order is a bid-ask price


Any broker can post a limit order
These are arranged at specialist desk
Last Trade = $50.00
market buy & stop buy orders executed at
lowest ask (effective ask price)
market sell & stop-loss orders executed at
highest bid (effective bid price)
10
Bid-Ask and Exchanges
11

Lowest Limit Sell: 45.60
Highest Limit Buy: 45.50

Ask: 45.60 Bid: 45.50

Market Buy



Buy at 45.60
Market Sell

Sell at 45.50
Bid-Ask and Exchanges
12

Ask: 45.60 Bid: 45.50

Limit Buy at 45.55




Limit Sell at 45.55




Order not executed. The lowest price at which you can currently buy is 45.60.
Order is entered in the limit order book.
New bid price becomes 45.55, highest limit order buy.
Order not executed. The highest price at which you can sell is 45.50.
Order is entered in the limit order book.
New ask price becomes 45.55, lowest limit order sell.
If these trades were both submitted by different investors, the specialist would
“cross these trades” and take them off the limit order book.
Bid-Ask and Exchanges
13

Ask: 45.60 Bid: 45.50

Stop Buy at 45.55


Stop Sell (Stop Loss) at 45.55



Order executed immediately. Buy price (45.60) is above the
threshold (45.55)
Order executed immediately. Sell price (45.50) is below the
threshold (45.55)
All stop buy orders are still executed at the ask
All stop sell orders are executed at the bid
FINANCIAL MARKET
EFFICIENCY
BKM: 8.1, 8.2
Investing

You’re considering whether you should buy a stock
for $10

You know that tomorrow the price will be $15.

What do you do?

What happens if other market participants have the
same information about Walmart that you do?
What we learn




When people know they can make money by taking a
simple action, they act quickly.
Some people are in a better position to receive/act on
the information than others.
Some people are willing to pay more costs to act on the
information than others.
When people act, the profit opportunity goes away
very, very fast.
Apparent Patterns in Prices
2000
1800
1600
1400
1200
1000
800
600
400
200
0
Predicting Stock Price Movements


Can we use movements in past prices to forecast
future returns?
Finding:
 Returns
are independent of movements in past prices.
 Random Walk with drift:
Pt  k  Pt 1  
E[ ]  0
 is independen t of past prices
like the outcome for a coin toss is independen t
of past coin flips
Which is the Real S&P 500?
2000
1800
1600
1400
1200
1000
800
600
400
200
0
New Thinking about Prices
Pt 1  Pt
 k 
Pt

 Pt 1  Pt

E
| past prices   k
 Pt

k
is just the reward on average you get for bearing the risk
of holding the asset.

is “new” information
Example

Longer horizon returns:
 Suppose
at the end of 2009 the price for a stock is 8.
 k=12% (annually)
 New information (In ) arrives that causes the market to
expect the price at the end of 2010 to be 12.
 If the price is 8 then E[rA|In]=12/8-1=50%
 Price therefore immediately jumps to 10.71, and causing
E[rA|In]=12%
 The realized return over the year will then be 12+ ,
where  is “new” information that arrives over the year.
Random Walk


Random stock movements are the necessary
consequence of intelligent investors competing to
discover relevant information.
Random stock movements are not proof of “market
irrationality”.
Implications



How do I forecast returns?
1) Find information “I”
2) Measure conditional expectation E[r|I]




Regression
3) If E[r|I]>k then BUY – stock is underpriced
Only information that is not already in the price will work.
If information is in the price, then E[r|I]=k.
Conditional vs Unconditional
rA
rI
12
-5
18
0.4
0.25
-10
0.05
0.3
E[rA | rI  12]  14.92
E[rA | rI  5]  2.74
E[rA ]  8.2
14.92 * .45  2.74 * .55  8.2
Implications





If all new information gets impounded in the price
very quickly, then E[r|I]=k for any information set I.
But then we can conclude that unconditionally, E[r]=k.
Implication: simple equally-weighted averages are
your best forecast of future returns.
Simple equally-weighted averages of past returns for
a given stock are estimates of k for that stock.
What information is already incorporated in prices?
Three Versions of the
Efficient Market Hypothesis

Weak-Form EMH
 Stock
prices already reflect all information contained in
the history of stock trading.

Semistrong-Form EMH
 Stock
prices already reflect all publicly-available
information.

Strong-Form EMH
 Stock
prices already reflect all relevant information
including inside information.
Three Versions of the
Efficient Market Hypothesis
past prices  public informatio n  all informatio n
Stong  Semi  Weak
Not Weak  Not Semi  Not Strong
It is possible for the market to be weak form efficient, but
not semi- or strong form efficient.
It is possible for the market to be semi-strong form
efficient, but not strong form efficient.
How efficient are markets?
Weak
Semistrong
Strong
Returns following Earnings
Announcements
Source: Patell and Wolfson (1984)
Mutual Fund Performance

Most actively-managed funds do not beat market
indices.
Median returns ending
12/31/2001
10 Years 15 Years 20 Years
Large Cap Equity
Funds
10.98%
11.95%
13.42%
S&P 500 Index
12.94%
13.74%
15.24%
Source: Malkiel (2003)
Mutual Fund Performance


There is not much persistence in mutual fund
performance.
How well did the top 20 Equity Fund in the 1980s
perform in the 1990s?
Average Annual Return
Top 20
1980s
same funds
1990s
Funds
18.0%
13.7%
S&P 500 Index
14.1%
14.9%
Assume Semi-Strong Form


Do analysts still add value?
Maybe just hire a blind monkey to throw darts on
the Wall Street Journal to select stocks.
Assume Semi-Strong Form

Rational security analysis is still useful:
 Monkeys
will probably not pick “efficient portfolios”
 Monkeys do not understand risk management
 Monkeys do not know the tax consequences
 Monkeys do not take your specific circumstances into account
(job, age, location).
Efficient Markets

In an “efficient” market, there will be rewards to
doing research.
Rewards
for
Research
Research
Conducted
Market
Efficiency
Efficient Markets


Rewards will be highest for those managing large
portfolios.
Example:
Suppose you have $10,000 invested
 Suppose research will yield a guaranteed increase in return
of 0.1% over the next year
 You get $10 woo-hoo!
 Now suppose you have $10 billion invested . . . .
